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After over a year of seeing the market move nearly straight up, it seems like everyone is waiting for markets worldwide to turn downward. But if you have a contrarian mind-set, you should instead consider the possibility that there's still money to be made in this market ... if you know where to look.
Value vs. momentum
In any strong advance, you'll find two sets of investors battling against each other. Value investors will argue that quickly rising stocks are losing their margins of safety, and are therefore now bad investments. For instance, as risky as things seemed a year ago, you could at least argue that buying Bank of America (NYSE: BAC ) shares for $3 or less was a reasonable bet on the recovery. Now, though, with shares approaching the $20 level, B of A is still facing shrinking year-over-year earnings -- not exactly an endorsement of the stock's huge advance, at least in a value investor's eyes.
Momentum investors, on the other hand, argue that investor behavior favors choosing stocks that have been rising lately. That means that rather than being bad values, stocks that have doubled or tripled have the attention of rank and file investors. It also means they are likely to keep turning that attention into higher share prices until something happens to reverse the trend.
So if going against the fearful crowd pushes you to look for momentum stocks, where should you look? Let's see what the numbers show.
Follow the money
The Wall Street Journal has an excellent tool for tracking what it calls "money flow," which it calculates by looking at the impact of each trade on the share price of a particular stock. To get a sense of where bullish money is going, I took a look at money flows on two key days for the market: March 5 and April 14, two of the strongest days for the market in the past six weeks.
As you'd expect, both days featured positive moves in nearly every sector. Among those sectors, though, financial stocks landed near the top of the gainers list on both days. Meanwhile, the telecom sector lagged behind both times, and health care actually saw outflows during Wednesday's rally.
So following a momentum strategy, that would suggest putting your money in the gainers and keeping it away from the laggers. But when it comes to picking individual stocks, it gets a little more complicated.
Even when a sector sees extraordinary money flows, individual stocks within that sector don't necessarily follow suit. On March 5, despite healthy inflows into the financial sector, Goldman Sachs (NYSE: GS ) topped the list of advancing stocks with net outflows -- arguing that investors were less confident in Goldman's rise compared to other industry stocks. That may be due to the fact that shares of both Goldman and fellow investment-broker-turned-bank Morgan Stanley (NYSE: MS ) have seen both their share advances stall out in recent months, while traditional banks have continued to see strong gains. Ironically, Goldman may be suffering because it didn't fare as badly during the financial crisis as other institutions and thus arguably had less to gain from the recovery -- although doubts about Goldman's future growth have also likely held both its and Morgan Stanley's shares back.
On April 14, though, when financials overall had the strongest inflows, both B of A and Wells Fargo (NYSE: WFC ) appeared near the top of this list -- perhaps due to reports that they might have to set aside tens of billions of dollars to reserve against losses on home equity loans. Such changes in momentum can indicate a healthy rotation of money among different stocks within a given sector -- or more ominously, suggest that a sector's rally is running out of steam.
Similarly, you can sometimes find diamonds among the wreckage of hard-hit sectors. On April 14, both Verizon (NYSE: VZ ) and Merck (NYSE: MRK ) saw shares drop despite the general advance -- but their money flows were both strongly positive. For Verizon, the optimism may lie in the new HTC Droid Incredible, which could help the telecom giant successfully challenge rival AT&T (NYSE: T ) for dominance in the fast-growing smartphone market. Merck's reasons for bucking the downtrend in health care are less clear, but the company's 4% dividend yield is attractive, it's reasonably valued, and some believe that the company actually stands to benefit from health-care reform.
The alternative view
Despite the market's lofty levels, momentum is suggesting that investors be buyers here. One of the hardest things to do is to keep your money at risk rather than taking a sure profit. Yet if you cut your winners too soon, you risk missing out on even bigger gains. Even though holding stocks based on momentum may feel wrong, it may well turn out to be the best move you can make.